Solvency II: Mission impossible
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Solvency II: Mission impossible

Regulatory capture, a pro-cyclical hike in capital costs and the intrusive micro-management of liabilities – the volley of criticism over European insurance reform, known as Solvency II, echoes the dissent that has blighted new banking regulation. It’s not clear whether even the 2016 deadline will be met.

Given the diversity of opinion and vested interests that vexes financial co-ordination in Europe – even with an apparent single market – forging a consensus on region-wide regulation is like trying to herd cats. Now there is an added imperative for politicians to deliver growth to voters at home and to protect their own national champions. What’s more, a rethink of aspects of bank regulation at the European and Basel-wide level has also contributed to reform inertia.

It’s no surprise, therefore, that efforts to conclude discussions on Solvency II – the fundamental review of the capital adequacy regime for the European insurance industry – are floundering, despite being in the works for a decade. Some market participants doubt the latest deadline of 2016 will be met, with a dispute on how much capital insurers should hold for guaranteed life-insurance products serving as the most recent stumbling block.

Solvency II was originally intended to create a level playing field, with a transparent calculation for capital weightings that would be applied consistently across all institutions, with beefed up asset-liability matching.

The insurance industry constitutes a substantial proportion of the European financial market, and hobbling it could constitute an economic blow. Yet failing to tackle systemic risk issues could allow for a repeat of the 2008 crisis.

There are valid concerns that high capital charges could push weaker insurers into raising capital in a constrained market, putting them and the wider economy under pressure. However, the regulatory uncertainty itself is undermining the recovery.

Philip Jarvis, Allen & Overy

“The continuing failure to deliver Solvency II has resulted in uncertainty, which has constrained insurers from undertaking potentially value-creating actions,” says Philip Jarvis, head of insurance at Allen & Overy. While it is natural for politicians to promote growth at a time of considerable recessionary pressure in Europe, this should be balanced by the first concern of regulators to ensure financial stability, says Jarvis.

“There is definitely a tug of war between long-term structural reform and short-term cyclical growth,” says Ross Pepperell, risk consultant at CheckRisk. “Unfortunately, politicians collectively missed a generational opportunity to make the necessary reforms in the wake of the global financial crisis.”

This has left Europe behind the curve globally, he adds.

This has sewn concern about the direction regulators are heading. Regulation is moving away from the ideal that, in a free market, institutions should be allowed to fail, and regulation should enable that to happen without creating overall systemic risk.

“Regulators have struggled to get the right mix of experience and insight in their policymaking,” says Jarvis. “We are not seeing an effective dialogue between the regulator and the regulated.”

Resolution is especially difficult to reach because there are no clear distinctions between those that favour pushing through tough regulations and those concerned about killing a recovery.

“Even people within single institutions are coming out with contrasting opinions about the right balance between risk and reward, and consumption and savings,” says Jarvis.

One such dispute is whether the micro-management of insurance liabilities, through the harmonization of risk-weighted models, will concentrate risk and is worth the regulatory scrutiny.

This top-down statist ideal of harmonized risk calculations has been undermined in banking at the European and Basel-wide level in recent years – which regulators this year have pledged to confront. Large banks have been given large scope to use their own models, signed off by their local regulators, creating opportunities for inconsistency.

The difficulty in accurately ascribing risk weightings to assets is illustrated by the experiences of the banking regulators in Basel. The treatment of securitization – treated as high risk – and sovereign debt, regarded as essentially risk free, have been especially contentious.

“A recent study by the European Banking Authority demonstrates that banks have exercised considerable discretion over how they apply risk weightings to their assets in calculating their capital requirements,” says Michael Wainwright, partner at Eversheds.

“It found that some banks were using risk models that required them to hold 70% less capital than their peers. The corresponding rules under Solvency II will be applied to insurers in a far more rigorous and prescriptive way.”

At the highest level it is recognized that the issue of bank regulation is more urgent, meaning Solvency II is not the top priority. “Policymakers’ primary concern is with saving the eurozone, and that means getting bank regulation right,” says Wainwright.

Optimists argue, once the economy picks up and pressure on the eurozone decreases, regulators will have more time to think about insurance regulation. Insurers will also be in a better position to cope with onerous new regulations.

And when the disagreements about Solvency II have been settled, it will probably mean adjustments to bank regulation as well, Wainwright predicts.

Pepperell says: “A certain amount of flexibility is needed, as opposed to dogmatism. However, long term, it is critical that the structural reforms take place and are not watered down by persistent lobbying, resulting in regulatory capture.”

By implementing aspects of the directive before the EU finalizes and rolls out the rules Europe-wide, the UK will provide a case study for the EU on how regulators could enforce tighter capital regulations without triggering distortions and onerous hikes in insurance costs.

Nevertheless, even after Solvency II is rolled out across Europe, most insurance companies expect to continuously modify their models in keeping with market forces and regulation to evolve accordingly.

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